US Taxpayer generously bails out the world(?)

Brad Setser -Sharing upside and downside risk

Prof. Brad Setser has a wonderful post on the US taxpayer bailing out “global” financial system. He examines the various ways in which the US could have bailed out the system while ensuring it gets something in return. The current bailout terms actually make the US taxpayer party to downside risks without any means to access the upside gains.

This touched a niggling thought in my mind. Is the US taxpayer carrying the burden of global financial system bailout?

US taxpayer is financing the “global” liquidity crises. Is it not similar to central bank intervening in domestic markets to provide liquidity? So in effect, the US is acting like central bank of the world. Then does the US have the clout/muscle to regulate globally?

If US attempts so - is a political transgression. Naturally, this will lead to diplomatic games that often result in lot of dinner and drink expenses and little else.

If not, US taxpayer is getting a raw deal. In effect, the already stretched taxpayer is bearing the global financial rescue burden. At this point, it is overwhelming. Add to it consumption responsibility that developing countries expect US to carry out. I think the system is near break. It is MUST that global leaders / central banks sit and hammer out the solution at a global level. Else, we will be perilous close to political turmoil.

Lehman, AIG and missing solution to global crisis

Goodbye Lehman
Lehman Brothers’ is no more. But, instead of cheering the Fed for not using tax-payers money, I think Fed has not fully nullified the threat. Moreover, I am siding with Lehman.

When something as old as Lehman fails, it must be one hell of a crisis. Actually, it is, and I have been harping on it. Yet the fact remains that something that survived the great depression will be no more. Many people have said that Dick Fuld was wrong in not selling to KDB. Yet surprisingly employees of Lehman I know – believe there must be a reason. Some say if you prick Dick Fuld, he bleeds green! They still believe in their top boss –even after the bankruptcy.

I do not believe that incredibly talented people at Lehman did something way different than what GS, MS and ML have done. There is something fundamentally wrong when you see Lehman and ML scurrying for capital – like there is no tomorrow.

Fed solution not complete
The Fed’s reaction to Lehman’s troubles was erratic. On one hand, it did not bail our Lehman but bailed out AIG. So they bust their argument about tax-payers money. I think Fed, with all the experience at the table, has failed to deliver creative solution to the crisis.

So where is the solution?
A single regulator, even as big as the Fed, cannot deliver a solution to current crisis. I think a global consensus needs to evolve. Global central bankers acting in sync can possibly solve this crisis sooner. It is time to take the John Pierpont Morgan solution. Get all central bankers into one room and lock the room until they get to the solution.

The current crisis begs for a need for new globally relevant regulatory framework. This framework needs to buy time for companies under attack – while not using any taxpayer’s money. However, looking at WTO, I think we are long way away from such a situation.

One other important learning from the crisis is that global accounting practices are not as robust as they seem. The root cause of this crisis rest in the accounting principles that allow asset values to move away from ground realities. Asset values moved along with fabricated-market realities leading to self-propagating bubbles.

Another accounting goof-up has been notional value changes creating real cash-flow profits. There is evidence of similar occurrence in a lot of trusts and funds. It seems irrational to me.

Aligned incentives are critical for firm survival. In this matter, I think Lehman was much better off. The employee benefit program tied long-term employees’ fate into the fate of the firm. I believe you cannot get better than this. A real hard look at compensation is definitely warranted.


Lastly
I end with a hope.
I hope in 2 years time, Dick Fuld and his team miraculously claws back with the Lehman Brothers’ name. I hope to see those golden letters on greenback on that building in Wall Street – just where they were for more than a century. I hope Dick Fuld has something up his sleeve. I really hope. And, I hope they do it soon.

Tim Duy explains current situation

Mark Thoma links to Tim Duys article on US and Japan equivalence here.

• The loss of US policy independence in accordance with the impossible trinity
• This poses threats to globalization in the context of US losing independence.
• US (excess consumption no saving) is polar opposite of Japan (lower consumption high savings).

This implies that for any real progress US demand contraction must happen. In this context, Larry Summer’s call for second stimulus may look ridiculous – but so long as global central banks are playing the game it doesn’t matter. To be fair, there is not much option left with Fed. Further, this is supposed to buy time – US may not be able to play this hand later in the game. I think this only postpones the inevitable fall of dollar.

The current new-found affinity for US dollar is actually repulsion to EM markets rather than affinity to US dollar. This money will go to newly spiced up US exporters. Exporters loose their competitiveness as it is derived from US dollar weakness. People loose money. It doesn’t matter in which currency you loose it – its lost. Loosing it in dollars makes it little better for the rest of us because there are just too many dollars sitting in vaults these days.

Welcome to the down-cycles.

Update:

Wall Street Journal concurs here. Link through The Big Picture - Barry Ritholtz

Cyclicality of global slowdown projection

In brief…
Current market slowdown will express itself in a cyclical matter with cycles accelerated or compressed within a short span of time. It is better not start pre-mature celebrations. It makes more sense to track the frontier of this storm wave. However, 5 years down from today we will marvel at the low-high-low-high forecast cycles wondering what were analysts thinking!

Into the cycle…
On the first anniversary of the slowdown, the US GDP was revised upwards much to the cheer of the markets. Experts like Tyler Cowen, Brad DeLong and others have already looked under the hood and have not found anything remarkable. US GDP seemingly grew on the back of strong manufacturing performance. The news coincided with a slowdown in Europe. This gave a chilling clue that possibly US growth came at the expense of a European growth. This newfound US competitiveness against the EU is primarily due to exchange rate weakness of the dollar. The dollar regained strength on the news of GDP uptick undoing the competitive forces. Thus, the situation is now ripe for US consumer uptick expectation and further realignment when it does not happen.

The down cycle oscillations…
The situation is likely to oscillate for at least another cycle. All the gains in competitiveness are still addressing American and European consumers. This, to my mind, is critical weakness of the currency system. I expect this cycle to oscillate until European consumers stop consuming at the next uptick, waiting for growth that is more fundamental and hence robust. Therefore, the last cycle will not produce a GDP increment as this time. The sooner this stabilizes the better. The more these cycles run on, the more loss of confidence will create panic. How long will this run and how spectacularly will it end is difficult to predict.

The consolidating cycles – more oscillations…
The next wave of cyclicality will hit when actually Chinese and Indian consumers hit the global markets. As global manufacturers rush to address this demand, they will unleash a new wave of competition. The resultant action will create a cyclical rebalancing in currency markets. Even this cyclicality will create an oscillation difficult to fathom/ predict.


The wavelength of the cycle…
Making money given the cyclicality of the world economy in the near-term, implies understanding the wavelengths of the cycles. As of now I believe we can only expect to understand down-cycle waveleangth. The consolidating-cycles will be far more complex and knowing their wavelength will be more difficult.

The down-cycles, as mentioned above, we can argue will have peak-to-trough time of at least 2 GDP reporting periods. Implying these will play out over little less than a year. Lead indicators of GDP like retail sales, car sales, energy consumption, inventories etc. also tend to influence markets during down-cycles. However, I think these indicators distort the way GDP growth diffuses through the economy and hence may mislead the markets. Actual GDP measurements may turn out to be more robust on upside and downside than predicted using lead indicators. Thus what was a single cycle may actually be aggregation of auxiliary-cycles. The main cycle though can be expected to follow GDP readings. The imposing auxiliary -cycles, if large enough in magnitude, can distort the wavelength.


In sum…
The near-future is going to be cyclical, with accelerated/compressed cycles. Most likely cycles will have wavelength (twice of peak-to-trough) of 4 GDP reporting periods. Auxiliary-cycles may play spoil-sport within the cycle. Making money in such an environment is equivalent to wave-surfing. At each peak you have to make enough to take you till the next peak! Thus making money is quite tough and entails highest risks. Welcome to the beach!

Central Bank problems - US investments, growth v/s inflation, Exchange rate hurdle

I am hearing repeated instances of global central banks now focussing on growth. Earlier, amdist the whirlwind shock wave of global economic downturn and rising oil prices, central bankers chose to slow the economy with a use of lagged monetary policy instruments. Now as oil and commodity prices subside, central banks look to fan the growth fires again. I believe most of it is a farce. Particularly so in case of China. Brad DeLong links to James Fallow's take on China in two parts first part and second part here. I think James Fallow has mis-interpreted the situation.

Formula economics
Emerging economies learnt the formula for growth in the past decade. It involved promoting investment and job creation, encouraging spending thereby triggering a virtuous cycle of development. This formula is great to initiate or prime the economy - but it is poor mechanism for transmission of wealth across income classes. Savings and host of economic factors ensure that the distribution of wealth so generated is lop-sided favouring the higher-income class.

The mistake
Most of the economies seems to have decided that answer to rising in-equality is in faster-higher-better priming. Partly, they cast their economies in the mould of market-share winning corporates. And like corporates these economies are intent on keeping "costs" down. The resultant "profits" were enormous and increasing. But there was a little difference with normal corporates. The employees of normal corporates interact back with the market. But employees of this nation-corporate only interact with themselves. (Either because of direct or indirect trade barrier like managed exchange rates) Therefore the higher profits could not be channeled into stake-holders - due to fear of inflation. So these had to be invested somewhere. So it is that this enormous forever-swelling pool of money found its way into US assets. Pushing the US consumer to carry this "little" extra burden. Then the unthinkable happened - US broke down - it was the last (Yuan) straw that broke the US back.

Where will Central banks find growth?
Now central banks are looking for growth. Now the same old principles wont apply. US consumer is not going to take any more burden. New consumers will have to be introduced into the system. China and India - these two countries who can inject tremendous amount of vitality into the system because of sheer numbers. But at current exchange rates both China and India are too small to carry the burden of US consumer.

Exchange rate correction will wipe out USD investment
As mentioned in yesterday's post, exchange rate revaluation will impact at least 2 trillion of China holdings. Opening the domestic market to world will further deplete this reserve. China will find itself in apparantly bad situation (first-order effect is pain). Fundamentally however this situation will better address the income discrepancy than its current policy - through third and fourth order effects. Yet can any country set aside the pain. I doubt - rather this will trigger a battle for consumer.

A confusing implication
Now there is a reverse implication of this. The "real" savings estimated in terms of purchaing power of future goods - will decline so long as exchange rate barriers dont break. This while savings are actually rising and inflation is low - and exchange rates are pegged. Anecdotally we can see amount of money required to maintain lifestyle is increasing faster than what inflation and wealth increase are telling us.

Key take-away
Exchange rate is key hurdle - from multiple sides - in addition to conventional fundamental reasons. There is going to be lot of pressure on Yuan at-least. Thats why my higher conviction on Yuan appreciation.

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Notes:
#) Some ideas half -developed - but important to highlight so posted half-baked.
#) James Fallow asked straight questions - I call them level 1 questions - we need to ask level 2 questions. E.g. relative pay-of to Chinese worker should be made in PPP terms or relative to China income distribution.
#) Just as I finished this I get this amazing article at Vox by Robert Dekle, Jonathan Eaton and Samuel Kortum. Will comment on it later.

China, US Dollar and making money in this situation!

Yves Smith is back to her best. She weaves together of thoughts on US situation, Chinese options and possible solutions at naked capitalism: Summers: "The global consensus on trade is unravelling". It raises many questions like Why is China buying US debt? And more generally Can you even think of making money in this situation? Here are my thoughts on the same.

China has limited options. A large part of its wealth is loaned to the US. Now the only volatile variable in this is exchange rate. If you have 2 trillion dollars sitting out there when exchange rate varies by 10% - I am sure you heart is in your mouth. If that much money has to retain value then it has to sit on something more robust than US debt!
For China, the only other way to retain value is to keep the relationship intact (because China CAN control one side of the peg!). But by committing to manage exchange rate - China now has no option but to be the large buyer of additional US debt. This is fine if China believes it can shore-up all the "remaining" US debt.
Now this situation is ripe for other nations, funds, entities to gradually off-load their USD holdings and retire to the peace of Euro, gold or some other value retainer. They are attracted by buying options for raw-materials i.e. food and energy. That makes the case for rising energy and food prices. This is same old logic behind this new-found attraction - hedging. Countries would ideally like to lock their costs in current prices to protect against future rise. So US debt problem now extends to US assets.

Where will China get the money to buy US assets?
While large part of the money comes from running trade surplus (for a little while), some part also comes through Chinese savings and investments. Chinese FDI is in a position to buy lot of US assets and given the situation - it will do so. Implication is if you have to shore up the Yuan for sometime and release it later - you will make a tidy dollar profit - if it is of any value.

So how do we retain - rather add value - sit on cash?
Sitting with cash (in local currency) is great stratgy for retaining value in local context. US domestic investors are ok with dollar profit - if they are going to spend it domestically. But most investors look to increase or at least preserve value. This was ok when dollar was default currency. It helped measure value - hence retain and enhance value. That was why nations bought US assets not because they were unusally attractive.
The other metric of value is the purchasing power. Lets say 10 dollars fetched one meal in 2008. Then all the current holdings should be measured in no. of meal terms. Then its easier to measure and enhance value again. So the best value retainers will be derieved from future consumption basket. So in-effect real hard-core hedging should help retain value. If smartly done - you may end up top of the heap.

Surely there is some hidden risk there too...
The situation becomes more critical if we realise that "contract enforcability" underlying the hedges can be threatened. This risk is sure to increase as money involved increases - i.e. when China realises it holds larger and larger share of US debt outstanding - and by that time China's stake would be probably greater than 4 trillion. Once China does realise - we are going to be in really, really tough times. In old times - this situation would be enough to cause a war. In today's times I hope not.

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Note: - The nakedcapitalism post is must read. It connects, complements and analyses this theme from Larry Summers FT article, Brad Setser (article I linked yesterday), William Greider, Dani Rodrik, Thomas Palley and El-Erian. I am fan of Yves Smith!
Also Steven Kamin has interesting findings at Vox.

A battle of minds for America's creditors

There is a great new post from Brad Setser at CPR. He highlights a quote from Dr. Yu Yongding that highlights the dilemma facing China as an investor in US debt.

“If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic … If it is not the end of the world, it is the end of the current international financial system.” "-Dr. Yu Yongding @ Brad Setser: Follow the Money

US creditors are in a waiting game. It is also a losing game. So long as they pick-up the US debt instruments, and supply more credit to US - things are fine. This is aggravating the US deficit problem. If US policymakers start rectifying the problem - they will do things that will upset this fine balance. It takes me back to my december 2007 post.

This waiting game has big money at stake. The pay-offs are larger and margin of error is small. This looks like a lose-lose game to me. What say ye?

Chinese Currency problem!

Real Time Economics : Economists React: 'Fundamental Alleviation Unlikely' for China

Its time to put higher conviction on my view that Chinese currency must appreciate. There is too much weighing in on the this side of the bargain that it will happen. Foreign currency inflows. to my mind, are anticipating a gain from one-time appreciation of the Chinese currency. Further let me speculate that with a one-off appreciation China will see a run on the currency. Foreign capital is likely to pull out possibly netting up to 15% return for the expedition.

This is running very similar to GBP devaluation. I would really love to know which side is Soros playing this time. After all its a known game for him.

The American Scholar - The Disadvantages of an Elite Education - By William Deresiewicz

The American Scholar - The Disadvantages of an Elite Education - By William Deresiewicz
(Jane McGonigal from Avant Game twittered about this link. ) talks about short-comings of US education. The most fantastic part for me was the following quote

Being an intellectual begins with thinking your way outside of your assumptions and the system that enforces them. But students who get into elite schools are precisely the ones who have best learned to work within the system, so it’s almost impossible for them to see outside it, to see that it’s even there. Long before they got to college, they turned themselves into world-class hoop-jumpers and teacher-pleasers, getting A’s in every class no matter how boring they found the teacher or how pointless the subject, racking up eight or 10 extracurricular activities no matter what else they wanted to do with their time.

During the earlier years innovation and challenging the boundaries by simple interaction of different cultures. There were barriers to cultures interacting. Thus top schools, by getting a diverse group together, facilitated the best learning environments. The system was right for the time.
Today technology has broken those barriers. Today learning must come from independent thought. And this is very difficult to induce independant thought. Schools are now trying to build on the diversity base, that they are familiar with, and add newer cross-discipline projects.

Cross-disciplining is expected to be next level of idea generation. Economics interacting with Physics, Medicine with mathematics, economics and thermodynamics - a lot of these fields are cropping up. I believe, education is in good hands. The most we can accuse it is for being slow with change.

Bailout, and government response - other view

There is an interesting post today at naked capitalism: Stiglitz; "Fannie’s and Freddie’s free lunch about justification of bailouts. US government is busy bailing out over-aggressive risk taking institutions with risk-averse sweat-and-blood money of the taxpayer who is more concerned about ways of paying his dues in a gloomy job market. This is wrong. But situation has grey areas when viewed from government side.

The institutions blame their woes on a US slowdown unashamedly pointing finger at the maxed out US consumer who has loan is past, present and future earnings to the devil himself. Let me remind you that these were the very devils who cheered on the US consumer down the valley of distress as they minted money at his/her expense. They sacrificed the consumer for the shareholder. As a reward, their shareholders lavished the boards and executives with benefits and bonuses. Today the US government is doing the exact reverse thing. It is bailing out the carefree risk-lords with shareholders’ money. At both side it is the layman at the receiving end. Yet it is not so simple.

From a government’s perch, the reality is confusing. Institutions are taxpayers themselves and hence stakeholders. They are also income sources and service providers for citizens. A large number of institutions are foreign exchange earners for their country. Governments view certain sectors as drivers of competitive advantage. US views finance and money management as its competitive advantage. A government might opine that a running system is easier to coax into order than let the system falter. Yet whatever the reason, they must be elaborated and opened to public scrutiny.

There are of course many lessons from the current crisis. Arnold Kling has thrown in his perspective here. However, that is when the sun breaks out. Right now, from within the eye of the storm, things are more difficult and often survival or preservation always gains top priority. We tend to salvage whatever we can even disregarding our lives. The roar of the catastrophy drowns the calls of prudence. I believe something similar is happening with governments globally. In their rush to do something – they may not necessarily do the right thing.

A comprehensive regulatory overhaul is definitely a take-away from this crisis. I believe, it is also important to take this regulation global. Further, taxation and social security needs to be overhauled. At the farthest “public goods” need to be defined and reworked. The most essential takeaway will be a disaster control program that tests scenarios and develops action plans to emergency alleviation. The system of academics, consultants and media (what we have currently) does not create enough accountability to identify scenarios and develop action plan. No doubt the system currently does that. But it is not treated seriously enough to become a disaster management system. Else the forecasts of lot of bloggers (including high profile ones like Dr. Roubini) would have triggered an enquiry.

Dollar and Yuan

We have two dramatic posts one detailing dethroning of the dollar at Vox and Yves Smith points to possible slow appreciation of Yuan here naked capitalism: China to Slow Yuan Appreciation? This is the essential dilemma that global central banks face today. The artificial currency pegs that Dr. Roubini calls Bretton Woods 2.

The first part dollar dethroning indicates that in the long term countries should not keep pegged to the dollar. The second argues that in the near term, China would refrain from un-pegging from the dollar. Now this is classic! If China sticks on to dollar too long, it will have to contend with inflation and systemic issues including devaluing reserves. On the other hand if goes for one-off devaluation it will expose its exports sector to global competition abruptly. But it will bring 300 million Chinese (the affluent ones) into the global consumer community. At the moment, that will be a big blessing.

Current exchange rate system is creating / forcing people to be global workers and local consumers. This benefits the local economy at the expense of global systemic balance. To ensure counter balancing we need global consumers and global workers supported by global capital and global regulation. By embracing the globalized system, all nations have committed to this balanced cooperative world vision. And I hope nothing we do can upset this eutopian step.

How did Germany avoid great inflation in 1979? � Mostly Economics

How did Germany avoid great inflation in 1979? Mostly Economics
Amol Agarwal points to interesting paper relating to German experience with inflation during the 1979 slowdown. Broadly the learning implies controlling the money supply using predictable medium term targets.

I do not believe at this stage simple controlling will help. This might result in excess money, accumulated in one part of the system (or big money), broadcasting it into the broader system. This permeation will absolutely guarantee high inflation. Conversely, less painful (for the masses) solution may be to keep excess money localized and slowly suck it out of the system.

In the US/UK today, the excess money has already permeated through the system. Increased debt burden and consumption triggered by rising house prices have already spread the excess money deep and wide. Hence a monetary tightening at this stage will have high adverse impact on US/UK population. More money in the system and alive and kicking employment alone could have been a solution if it weren't for the high household debt. Household debt burden simply inflates if value of money goes down. Hence bankruptcy laws and loop-holes therein are most critical. Prof. Elizabeth Warren realizes this and hence her strong emphasis on modification to bankruptcy laws. I understand South Korea, Australia and EU are in same situation as US/UK.

In the rest of the world, the money has not permeated as well. Sovereign funds, reserves and to some extent big money have limited the spread. In any case situation is better than US/UK. Here monetary tightening might be a useful tool. Emerging markets and other countries could do better than emulate the west in this regard.

The future is tough! Let us just hope we don't forget the lesson this time!